by T. GormanPosted on Posted in SECActions

This is the second segment of a five part series discussing the impact of the Second Circuit’s ruling in Newman on SEC insider trading cases

The Immediate Impact of Newman

The most immediate impact of Newman is on pending criminal and civil cases. This is illustrated by the decisions in U.S. v. Conradt, 12 cr. 887 (S.D.N.Y.) and SEC v. Payton, Civil Action No. 14 civ 4644 (S.D.N.Y.), two parallel enforcement actions. Both cases center on the acquisition by I.B.M. of SPSS. Both alleged illegal tipping in violation of Exchange Act Section 10(b). Both are based on the same facts. Yet there are opposite results – the criminal charges were dismissed. The SEC charges survived a motion to dismiss and the case is in litigation.

1. Background

The illegal tip traces to attorney Michael Dallas, an associate in a New York law firm assigned to work on the deal. Mr. Dallas was close friends with broker Trent Martin. The two men had a history of sharing confidential information. Beginning in the spring of 2009 Mr. Dallas told his friend about the SPSS deal. Over time he provided updates. Both men understood that the information they shared regarding their work was non-public and confidential. Both expected that confidentiality would be maintained.

Mr. Martin was roommates with Thomas Conradt, an attorney employed at another New York brokerage firm. They had a close, mutually dependent financial relationship with a history of personal favors. Mr. Martin told his roommate about the SSPS deal. Mr. Conradt purchased shares of SPSS prior to the deal announcement on July 28, 2009.

Messrs. Payton and Durant were co-works of Mr. Conradt. The three men had discussions about Mr. Conradt’s roommate – Trent Martin. Each knew that Mr. Martin worked at a brokerage firm. Mr. Conradt told his co-workers that he learned about the SPSS acquisition from his roommate. Messrs. Payton and Durant did not ask more about the roommate. They did purchase shares of SPSS just prior to the public announcement of the deal. In addition, Mr. Conradt is alleged to have tipped David Weishaus and three others who worked at the same brokerage firm. Each tippee traded.

2. The criminal cases

Messrs. Conradt, Weishaus, Martin and Payton were each charged with insider trading. Each pleaded guilty prior to the decision in Newman. Following the Second Circuit’s decision in Newman, Judge Carter vacated the guilty pleas and dismissed the criminal charges. U.S. v. Conradt, 12 – 887 (S.D.N.Y. Order Dated January 22, 2005). Under Rule 11(b)(3) of the Federal Rules of Criminal Procedure the district court has an “obligation up through the entry of judgment to vacate a previously-accepted guilty plea and enter a plea of not guilty on behalf of a defendant if it becomes clear that there no longer is a sufficient factual basis for the plea,” Judge Carter held. This is in accord with established Second Circuit decisions such as U.S. v. Calderon, 343 F. 3d 587, 589-90 (2nd Cir. 2001) which require the court to determine if there is a factual basis for the plea by matching the facts in the record with the legal elements of the crime.

Here Newman is the controlling case, defining the elements of tipping liability under either the classic or misappropriation theory of insider trading, according to the Court’s order. While the Government contended that this statement in Newman need not be followed because it is dicta, the Court rejected the contention noting that “Newman’s unequivocal statement on the point is part of a meticulous and conscientious effort by the Second Circuit to clarify the state of insider-trading law in this Circuit. Accordingly, even assuming arguendo that the Government is correct that the cited language in Newman [that the personal benefit test applies to both theories of insider trading] is dicta, it is not just any dicta, but emphatic dicta which must be given the utmost consideration.” Accordingly, the guilty pleas were vacated. In a subsequent order, dated February 3, 2015, the Court dismissed the indictments without prejudice. Other defendants in criminal cases are either seeking to vacate their guilty pleas or have their conviction reversed on appeal based on Newman. See, e.g., SAC Manager’s Tipper Says Newman Voids Plea, Sentence, Law 360 (May 5, 2015), available at www.law360.com/articles/651882/print?section=securities

3. The SEC case

Since Newman is based on a construction of Exchange Act Section 10(b) its teachings should apply with equal force in either a criminal or civil action. See, e.g., U.S. v. O’Hagan, 521 U.S. 642 (1997)(adopting misappropriation theory of insider trading in criminal case which applies also to civil cases); see also Aaron v. SEC, 446 U.S. 680, 691 (1980)(rejecting SEC contention that scienter applies to civil damage actions based on Section 10(b) but not SEC enforcement actions). Nevertheless, in the SEC’s civil enforcement action which parallels Conradt, Judge Rakoff appears to have drawn a line between civil and criminal insider trading actions is refusing to dismiss the action based on Newman. SEC v. Payton, Civil Action No. 14 civ 4644 (S.D.N.Y. Opinion issued April 6, 2015). See also SEC v Conradt, Civil Action No. 12-cv-08676 (S.D.N.Y.).

In Payton Judge Rakoff began by stating that there is a difference between criminal and civil cases. In the former the “court is obliged to define unlawful insider trading narrowly, so as to provide the fair notice that due process requires . . .” In the latter, typically brought by the SEC, “the court is inclined to define unlawful insider trading broadly, so as to effectuate the remedial purposes behind the prohibition of such trading.” The Court did not cite any authority for these propositions. Judge Rakoff did, nevertheless, state that to properly plead tippee liability the SEC must set forth facts in its complaint which are sufficient to meet the Newman test. Those facts must be construed in favor of the SEC.

Under Newman the first question is whether the SEC has sufficiently alleged that Mr. Martin, the tipper, received a personal benefit when furnishing the inside information to his friend, Mr. Conradt. That requirement has been met, Judge Rakoff found, because the SEC alleged that Mr. Conradt had a mutually dependent financial relationship with his friend, a history of personal favors and their expenses were “intertwined.” Mr. Conradt “took the lead” in organizing and initially paying for shared expenses. He also assisted his friend with a criminal charge. Later the two men had a conversation in which, according to the complaint, “Martin thanked Conradt for his prior assistance with the criminal legal matter and told Conradt he was happy that Conradt profited from the SPSS trading because Conradt had helped him.” These allegations support an inference of a quid pro quo relationship, the Court found.

The second critical question is whether the defendants knew of the benefit. Here again, the allegations of the complaint are sufficient, the Court concluded, when all inferences are drawn in favor of the SEC. Those allegations demonstrate that the defendants knew Messrs. Conradt and Martin were friends and roommates and that Mr. Conradt assisted with the criminal matter. “This is enough to raise the reasonable inference that the defendants knew that Martin’s relationship with Conradt involved reciprocal benefits,” according to Judge Rakoff. This inference is bolstered by the fact that Mr. Durant repeatedly asked Mr. Conradt if additional information could be obtained from his roommate – and it was secured.

Finally, the two defendants took steps to conceal their trading activity while avoiding any discovery of the circumstances surrounding the tip between Messrs. Martin and Conradt. The latter is evidence of “conscious avoidance of details about the source of the inside information and nature of the initial disclosure,” according to the Court. Collectively, these allegations are sufficient to survive a motion to dismiss based on Newman.

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by T. GormanPosted on Posted in SECActions

The Impact of Newman on SEC Enforcement: Part I

This is the first segment of a five part series discussing the impact of the Second Circuit’s ruling in Newman on SEC insider trading cases

Introduction

In seeking rehearing and an en banc hearing before the Second Circuit Court of Appeals the Manhattan U.S. Attorney’s Office told the Court that the panel decision in U.S. v. Newman, Case Nos. 13-1837, 13-1917 (2nd Cir. December 10, 2014), would undermine the ability of law enforcement to effectively police the securities markets for insider trading. Petition of the United States of America for Rehearing and Rehearing En Banc, filed January 23, 2015 (“Petition for Rehearing”) at 22. The SEC, in an amicus brief, concurred. Brief for the Securities and Exchange Commission as Amicus Curiae Supporting the Petition of the United States for Rehearing or Rehearing En Banc, filed January 29, 2015 (“SEC Brief”) at 11. The Court denied the request for rehearing. Newman is the law, at least in the Second Circuit.

Unless Newman is overturned by the Supreme Court, the decision will remain the law in the Second Circuit and perhaps others in view of the Court’s influence in securities law. The impact of Newman thus becomes a critical issue for SEC enforcement. To assess the potential impact of Newman on SEC enforcement four key points should be considered: 1) the decision; 2) its impact on existing criminal and civil cases; 3) its impact on SEC cases; and 4) analysis.

The Decision in Newman

Todd Newman and Anthony Chiassons, remote tippees, three to four steps removed from the source of the inside information about pending earnings announcements for Dell, Inc. and NVIDIA, were convicted of insider trading. In reviewing their convictions the Second Circuit stated: “ We note that the Government has not cited, nor have we found, a single case in which tippees as remote as Newman and Chiasson have been held criminally liable for insider trading.” U.S. v. Newman, Nos. 13-1837-cr, 13-1917 (2nd Cir. Decided December 10, 2014). The Second Circuit drew a clear line regarding the requirements for tipper liability using the “personal benefit” test crafted for the protection of analysts by the Supreme Court in Dirks v. S.E.C., 463 U.S. 646 (1983). The convictions were reversed.

Todd Newman and Anthony Chaisson were portfolio managers at, respectively, Diamondback Capital Management, LLC and Level Global Investors, L.P. Both were convicted of insider trading in the shares of Dell and NVIDIA following a six week trial. Both were remote tippees. With regard to the trading in Dell, the inside information went down a chain: Company employee Rob Ray transmitted the earnings information to analyst Sandy Goyal, who in turn tipped Diamondback analyst Jesse Tortora who then told Mr. Newman and Global Level analyst Sam Adondukis who told Mr. Chaissom. Each portfolio manager traded.

The inside information regarding NVIDIA traveled a similar, lengthy path to the two portfolio managers. It began with company insider Hyung Lim who passed the information to Danny Kuno who furnished it to Messrs. Tortora and Adondukis who transmitted it to, respectively, Mr. Newman and Mr. Chaisson. Each portfolio manager traded in NVIDA shares.

At the close of the evidence each defendant made Rule 29 motions for acquittal, arguing that tippee liability derives from that of the tipper. Since here there was no evidence that the corporate insiders obtained a personal benefit the charges should be dismissed. The District Court reserved judgment and sent the case to the jury for consideration based on its instructions. The defendants argued that the jury charge on tippee liability should include the element of knowledge of a personal benefit received by the insider. The Court gave the jury an alternate instruction which stated in part that the Government had to prove that the insider “intentionally breached that duty of trust and confidence by disclosing material nonpublic information for their own benefit.” The instructions also stated that the defendant had to “know that it [the inside information] was originally disclosed by the insider in violation of a duty of confidentiality.” The jury found both defendants guilty of insider trading.

The Second Circuit disagreed. The Court held that the jury instructions were inadequate and that the evidence on tippee liability was insufficient. Accordingly, the convictions were reversed and the charges dismissed with prejudice.

The Court began its analysis by reviewing the basic tenants of the classical and misappropriation theories of insider trading. The elements of tipping liability are the same regardless of the theory utilized, according to the Court. Under Dirks the test for determining if there has been a breach of fiduciary duty is “’whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty . . .’” the Court stated, quoting Dirks. The tippee’s liability stems directly from that of the insider. Since the disclosure of inside information alone is not a breach, “without establishing that the tippee knows of the personal benefit received by the insider in exchange for the disclosure, the Government cannot meet its burden of showing that the tippee knew of a breach.”

In reaching its conclusion the Court held that “nothing in the law requires a symmetry of information in the nation’s securities markets.” That notion was repudiated years ago in Chiarella v. U.S., 445 U.S. 222 (1980). While efficient capital markets depend on the protection of property rights in information, they also “require that persons who acquire and act on information about companies be able to profit from the information they generate.” It is for this reason that both Chiarella and Dirks held that insider trading liability is based on breaches of fiduciary duty, not on “informational asymmetries.”

Based on these principles, the elements of tippee liability are: (1) the corporate insider had a fiduciary like duty; “(2) the corporate insider breached his duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade. ..” Since the jury instructions did not incorporate these elements they were incorrect.

Finally, in reviewing the sufficiency of the evidence, the Court gave definition to the personal benefit test. That test is broadly defined to include pecuniary gain and also reputational benefit that will translate into future earnings and the benefit one would obtain from making a gift of confidential information to a relative or friend. While the test is broad it does not include, as the Government argued, “the mere fact of a friendship, particularly of a casual or social nature.” A personal benefit can be inferred from a personal relationship but “such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature. In other words . . . this requires evidence of a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the latter.” (internal quotes omitted). Here the evidence is not sufficient to meet this test. The Second Circuit subsequently denied a motion for rehearing by the U.S. Attorney.

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